An index architect’s perspective on China’s expansion of QFII program

Despite a volatile start to 2016, the desire on the part of international investors for greater access to China remains high and it continues to raise its profile on the global stage as a market of central importance. The FTSE China A50 Index has fallen 21% over the last year (as of March 31st) and a growth slow down for the world’s second largest economy has tested investors’ resolve, yet the strategic importance of China and how to access it is one of the most frequently discussed topics when we meet with our clients.

Why? Aside from the large economy and diversification benefits China brings to a global portfolio, investor interest has increased with the stock market expansion, regulatory improvements and increasing market accessibility. For example, a quick comparison of the China A50 Index of 10 years ago to that of today tells a compelling story. The total market cap of the index grew from $41.2 billion at March 31st, 2006 to $524.8 billion at March 31st, 2016, recording a 13% annualized index return (this compares to a 7% annualized index return for the US large cap Russell 1000® Index for the same period). And the sector changes for this index over the last decade reflect a maturing economy. For example, the weights of the oil & gas producer and mining sectors decreased from 5.5% and 13.6% respectively of the index in March 2006 to 2.3% and less than 1%, respectively, in March 2016. On the other hand, the weights of banks and financial services increased from 20.3% and 0.9%, respectively, in March 2006 to 42.3% and 11.5% of the index, respectively, in March of 2016.

Market accessibility has increased with the introduction of the RQFII scheme for qualified investors and the Shanghai-Hong Kong Stock Connect program for all investors, and enhancements to the long-standing QFII program. For foreign investors to gain access to the A-shares market, they must do so through a managed quota system, so any expansion or relaxation of these managed quotas is quite significant to these investors. The Peoples’ Bank of China (PBoC) has also announced that it will remove the quota system for international investors to access the interbank bond market.

The rapid pace of recent announcements by China’s State Administration of Foreign Exchange (SAFE) has broadened the allowable scope of foreign investment, made existing programs easier to use and clarified rules like tax treatment. Expanded access has gone hand-in-hand with government financial and market reforms, including adjustments to interest rate policy, banking systems and currency.

With increasing China investment quotas, the question our clients most often ask is how to best access this market. The answer in short: thoughtfully, methodically and patiently. The current set of share classes available - a veritable alphabet soup including A, B, H, S, N, Red Chip and P Chip shares - provides a sense of the varied tapestry faced by investors considering access points. A recent FTSE Russell Index IDEA – China Deconstructed – shares some recent performance figures to help illustrate this point.

This market complexity and speed of increased accessibility all begs the need for a steady hand from investors and index providers alike. For architects of global indexes used by China market participants, a thoughtful framework, robust methodology and a firm governance structure form an essential blueprint for managing China change.

FTSE Russell’s governance framework guides decisions on how we build and maintain our global indexes. This is important for every index we offer, but even more critical for quickly evolving areas of the world. The FTSE Country Classification process classifies all countries contained in FTSE’s global benchmarks as Developed, Advanced Emerging, Secondary Emerging or Frontier while providing a Watch List of countries where classification may change in the near term. China’s A share market is currently on the FTSE Watch List to join other existing China share classes in the Secondary Emerging category.

FTSE’s Country Classification Advisory Committee, a group of independent and experienced market practitioners, assesses each country on 21 “Quality of Markets” criteria, and on the country’s economic status as measured by GNI per capita. On the basis of this framework, FTSE Russell presents its assessments to a senior-level Index Policy Advisory Board for further discussion. September’s Annual Country Classification announcement is approved by FTSE Russell’s internal Governance Board taking the FTSE Country Classification Advisory Committee and FTSE Russell Index Policy Advisory Board recommendations into consideration.

Our framework must at once be consistent and enduring, able to recognize change and adjust our treatment of markets, companies and share classes as conditions evolve over time. And we avoid operating in a vacuum, instead working closely with the institutional investor community and market authorities to ensure our indexes are relevant to the market. It's a delicate balancing act, essential to maintaining benchmarks that serve as relevant and investable global market proxies.

This framework helps guide our opinions and actions on China as it evolves. In 2015, for example, we launched the FTSE China A Inclusion Indexes as a set of transitional tools providing our clients with a choice of how to include China A shares in global benchmarks. A recent research report outlines the market backdrop in China and considerations governing our decision to gradually begin offering China A shares in our global benchmarks.

Going forward, as part of the 2015 Annual Country Classification Review, China remains on the FTSE Watch List for possible inclusion in Secondary Emerging. We recognize the latest SAFE announcement is a major step forward for market access and capital repatriation. This will be raised by the FTSE Country Classification Advisory Committee ahead of the formal interim update later this month.

We enjoy an open and positive dialogue with the Chinese authorities and will continue to review and assess recent developments. As a leading global index provider we must have a strong insight into the evolution of the global equity markets so we can provide the most accurate and representative tools for our global investor clients. Click to read more about our China indexes.

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Views expressed by Jonathan Horton are as are as of April 14th and subject to change. These views do not necessarily reflect the opinion of FTSE Russell or the London Stock Exchange Group.

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